Chapter 20/      Overview of Macroeconomics

Economics science tries to define how people and society chose to use money or not to allocate different resources through time and distribute them for present and future consumption among people in the society.

Economics science contains two distinct branches:

Macroeconomics and Microeconomics. The last one is concerned with the behaviour of individuals or a well defined group of people at the production, exchange, and consumption levels. The first one is concerned with the behaviour of the economy as a whole; macroeconomics science is primary related to the economy of nations. Through macroeconomics science nations can calculate their gross domestic product, their rate of employment, their price stability and their foreign trade.

In the process of judging the economy of a given nation, economists have to consider 4 indicators:  

  • GDP
  • Employment
  • Price Stability
  • Net Export


These four indicators are not equal in terms of importance, but they should all be taken in consideration to give a reliable judgement.

Click on on the following link for a general-need definition of Macroeconomics: http://socyberty.com/economics/macroeconomics/

Lets discuss each one of them more deeply in order to well emphasis their importance in your mind and understand their uses.

1.  GDP or Gross Domestic Product is the total amount of goods and services produces in a country by the business sector during a year.

PS/   Do not confuse between the GDP and the GNP.

The GNP or the Gross National Product is the total amount of goods and services produced by people having the same citizenship during a year.  

Example:    The production of a Japanese company that produce car in the U.S.A. will be counted in the calculation of the GDP but not in the calculation of the GNP. Of course we are talking here about the U.S.A. GDP and GNP. On the other hand, the production of a U.S.A. company in Japan will not be counted in the calculation of the U.S.A. GDP but it will be counted in the calculation of the Japanese GDP.


The main purpose of all kinds of economies in the world is to provide goods and services to satisfy consumers’ needs, and one of the main measures adopted by a large range of countries to calculate a nation’s total production is the GDP.

There are a lot of variants of GDP such as NGDP, RGDP, and P GDP or Potential GDP which was first adopted by the U.S.A. to always keep a close look at their economic performance.

Potential GDP is the maximum sustainable output that an economy can produce by combining factors of production available at a given time.

Potential output depends on the availability of factors of production (Land, Labor, Capital) and the nation’s level of technology and managerial efficiency.

·        A nation that is producing above its Potential GDP should be either importing Capital or labor or both of them. Of course such as nation should has a 0% rate of unemployment, and a fast growing GDP.

·        A nation that is producing on it Potential GDP, is taking full advantage of the factors of production available within its boarders.

·        A nation that is producing under its Potential Output should be under using its factors of production, either it has a positive rate of unemployment, or not all its Capital is invested or a combination of these two things with maybe other factors that I didn’t mentioned.

The GDP gap is the difference between a nation’s potential GDP and Its Nominal GDP*.

2.  Unemployment: from all macroeconomic indicators, unemployment is the most felt by people. All nations try to keep a low rate of unemployment.

The unemployment rate is calculated using the following formula:

%unemployment = (unemployed people / Labor force)

%employement = (employed people/ Labor force)

The Labor force of a nation is the sum of all people forming the nation, excluding the ones who are not looking for job and the ones who are under the legal age to work. In some countries like the U.S.A. they exclude also people who are serving in the army and other special cases.  

The unemployment rate is the indicator that most reflect the stages of the Business Cycle. “Think about it”.

3.  Price Stability. All countries are looking for Price Stability which means a price level who is constant or a least, is growing steadily at an acceptable rate. Economists measures price stability by looking at the rate of inflation.

To track prices, nations adopted a wild range of indexes. The most common one is the consumer price index or the CPI. CPI is the average price of goods and services bought by consumers. The method of calculation of the CPI differs from a country to another. For the case of Morocco, the CPI is calculated using the Laspeyres Method.

The Laspeyers method of calculation is as follow:   I = (∑ P0Q0 / ∑P1Q1)*100

The CPI is used in the Calculation of the Inflation rate.

The inflation rate is the percentage change in the overall price level from one year to another.

The inflation’s rate formula is as follow:  


%Inflation (2001) = (CPI 2001- CPI 2000/CPI 2000)

The inflation standards:  

Between 0% and 9%    it is a moderate inflation.

Between 10% and 20%    it is inflation.

          Above 20% it is a hyper Inflation


The relationship between the GDP and the Price is positive:

When GDP increases the price also increases.

When GDP decreases the price also decreases.


4.      The Net Export: 

Net export is the difference between the money value of a nation’s export and Import.

Government can regulate a nation’s trade activities using trade policies that consist of adopting quotas, tariffs…. Regulate means either encourage or restrict.

The net export is closely related to a very important variable called the Exchange Rate.

The exchange rate is the value of a country’s currency in terms of other nation’s currencies.

Discussion: When the exchange rate decreases the rate of inflation tend to increases.

A county with a low exchange rate will tend to export at a low price and to import at a higher price. With expensive imports, the prices within the country will tend to rise up which is a clear signal of an increase of the inflation rate.

Some countries chose to set the value of their currency up, so that their foreign exchange rates stay always high. By adopting this kind of policy, such as countries try to export their output at the highest possible price. Not all countries can do such a thing; in fact it depends on the kind of output that the country is willing to export. If the demand on these kind of output is inelastic a country can adopt this policy, if not, it can’t.

Foreign exports standards:

When the money value of a country’s export is higher than the money value of it’s import then we say that the country has a foreign trade surplus.

When the money value of a country’s import is higher than the money value of it’s export then we say that the country has a foreign trade deficit.

When the money value of a country’s export is equal to the money value of it’s import then we say that the country has a foreign trade balance.

Now we are done with the four macroeconomic indicators, while we were developing the topic, we tried to give some definition of macroeconomic key terms. Remember???? (GDP, Potential GDP, Inflation rate, unemployment, exchange rate, CPI, Labor force, Micro/macroeconomics, economics, GNP,… ).

Now let’s move to talk about Aggregate Supply and Demand.

Aggregate supply is the total amount of goods and services that the business sector willingly produces and sells in a given time.

Aggregate demand is the total amount of goods and services that consumers are willingly and able to buy in a given period of time.

The equilibrium macroeconomic position is a combination of overall price and quantity at which all buyers and sellers are satisfied with their purchases, sales, and prices.

On a diagram the equilibrium macroeconomic position is represented by the intersection point of the AS and AD curves.


Chapter 21/ Measuring Economic Activity. 


Of all concepts in Macroeconomics, the single most important one is The GDP. GDP is part of the national accounts, which are a body of statistics that enable policy makers to make decisions about the nation’s economy.


GDP is the name we give to the total market value of the final goods and services produced within a nation during a given year. It is the sum of aggregate consumption (C), gross Investment (I), government expenditures (G), and net export (X-M) in a nation during a given year.


The Basic Macroeconomic Equation.


∑y = Y = GDP = C + I + G + (X-M)


Our discussion of the elements of national income and Product accounts will focus on four main points:


  1. The flow of product and earning or cost approaches to calculate the GDP.

  1. Real Vs Nominal GDP.
  1.  Analyzing major components of GDP.

  1. Discussion of the measurement of the general price level and rate of inflation.



Two Independent approaches to calculate the GDP/


There are two perfectly independent approaches to calculate a nation’s GDP.


The flow of product approach:  Under this approach, the GDP is defined as the total money value of the flow of final goods produced by the nation.

The Earning or cost approach: The second way to calculate the GDP is to sum up the total of factor earnings (wages, interest, rent, and profit) that are the costs of producing a nation’s final product.

The expenditures on goods and services by consumers provide income for firms. Similarly government’s expenditures on goods and services provide income for firms that are providing the goods and wages to workers who are rendering the services. Thus the flip up of the product flow approach is to add together the income of different components of the economy.


Wages + Rent + Interest + Profit


market value of final goods and services produced in a nation during a year.



In fact both approaches are identical because we have included profit with the other incomes.

What is a profit???

Profit, “in a Macroeconomic course”, is what is left from the sales of a good or service after paying out all the factor costs –wages, rent, and interest. Most of the time, profit is said to be the residual that is left after paying all factor costs.

A reader may say <<But wait!!!   In the first approach, you said that while calculating a nation’s GDP we have to pay attention to not fall in the double counting problem, and thus, we have to include only the market value of final goods and services in our calculation. OK up to know I agree. But, what about the problem of double counting in the cost approach. When we gather income statements from the accounts of firms, will not we pick up what eggs merchant paid to farmers, and what backers paid to merchant? If we do so, we will be counting the eggs’ cost twice, which will lead us to an overestimation of the nation’s GDP. >>  


To avoid the double counting in the cost approach, statisticians invented a measure called the Value Added.

  1. The value added of a good A equals its market value, minus the value of intermediate goods used in its production.

  2. The value added of a good A equals the value of production factors used in its production plus the profit (residual).


A short rap up:

            To avoid double counting, we take care to include only final goods in GDP and to exclude the intermediate goods that are used up in making these final goods. By  measuring the value added at each stage, taking care to subtract expenditures on the intermediate goods bought from other firms, the cost approach will properly all double counting.

Nominal Vs Real GDP/

GDP is the dollar value of final goods and services produced in a nation during a year.

In this part, we will concentrate mainly on the two world highlighted in the previous line.

Dollar value. You probably know that the dollar’s value change each second. Today’s dollar is not equal to yesterday dollar. So in the definition above, about which value are we talking? Is it the current value, is it yesterday’s value, or maybe last year value? In fact, it depends. Depends on what? It depends on which GDP are we talking about. I forgot to tell you. There are many variants of the GDP. The most important and frequently used ones are Nominal and Real GDP.

Nominal GDP (PQ) is the total amount of goods and services produced in a nation during a year. The values of these goods and services are evaluated on the basis of a current market price.

Real GDP (Q) is the total amount of goods and services produced in a nation during a year. The value of these goods and services are evaluated on the basis of based year’s market prices.

Got it now?? I Hope so.

We can conclude that nominal GDP is calculated using changing prices, while real GDP represents the changes in the volume of total output after price changes are removed.


The GDP deflator is the difference between the growth in nominal GDP and Real GDP.


Q = Real GDP = (Nominal GDP)/(GDP price index) = PQ/P



Details of the National Accounts/


GDP = C + I + G + (X-M)

Let’s discuss each component of the equation above.

Consumption: the most single important part of GDP is personal consumption expenditures. It’s by far the largest component of GDP in most countries. Consumption expenditures are divided into three categories:

1.      Durable goods

2.      Nondurable goods

3.      Services. (The most rapidly growing one)

Investment and Capital formation: from the very beginning of this paper, we neglected the economic side that focuses on Capital, by assuming that all what a nation may produce is consumed by its household sector. In reality, nations do not produce only final goods, it also produce goods and services that are used to produce other goods and services. This kind of goods is called Capital. “Intermediate consumption goods”. To produce Capital goods, a nation must sacrifice a part of its current consumption and because resources are scare and limited, a nation that does not produce capital goods will die. The best example to illustrate this idea is the KSA’s and Nauru’s stories. KSA is ranked as the first oil producer in the world; 95% of its income is coming from oil export. Since 1970s the KSA’s government has understand that oil is a limited resource that will not be there forever. For this reason and others, the country decided to sacrifice, a reasonable part from its income to invest it and produce Capital goods (building, hospitals, conducting researches, building schools...). In the short run, the country will not benefit from these Capital goods, but in the long run, this kind of policy will be very useful and will bring benefits to the country. The second story, which is completely different from the first one occurred in Nauru. Nauru is a small island in the Pacific Ocean. Few years ago, Nauru was known for its natural resources, especially the Phosphate. Through the phosphate’s export, the country was one of the richest countries in the world and it recorded one of the highest GDP per capita in the world. Unfortunately, and because of problems at the governmental level, the country didn’t invest in Capital goods, and spent most of its resources on consumption goods. Once the phosphates stocks were gone, Nauru returned to its previous state and became one of the poorest countries in the world.

From these two examples, we can see and understand the importance of Investment in Capital goods.


Let’s return to where we were.

The national accounts include mainly tangible capital, but omit most intangible capital such as research and development.

How does investment fit into the national accounts? If people are using part of society’s production possibilities for capital formation rather than for consumption, economic statisticians recognize that such outputs must be included as investments. A nation’s investments represent additions to its stock of durable capital goods that will increase its production possibilities in the future.


The new GDP’s definition:  the sum of all final products produced in a nation during a year plus the nation’s gross investment.



Net Vs Gross Investment.


The only difference between the gross and net investment is that while the net investment is adjusted for depreciation, the gross investment is not adjusted. Then we can say that

Net investment = Gross investment – depreciation.

Measuring a nation’s capital using gross capital consists of summing up the amount of capital that has been invested during a year. EX: a company A invested $300000 to buy a more efficient machine to replace the old one that was both for £280000. Buying a machine is an investment because a physical capital good is produced. Under the gross investment approach, the company’s total capital is £580000. Under the net investment approach, the company’s total capital would be (300000+280000) less the depreciation of the first machine which is equal to 280000 because it will be no more used. Isn’t it.


Government: the government is one of the most important components of a nation’s economy. In general it is the biggest buyer and investor. In measuring government contribution to the nation’s GDP we simply sum up the government purchases to the flow of consumption, investment and net export.

Hence, all government payroll expenditures on its employees plus the costs of goods it buys from private industries are included in what we call the government consumption expenditures. From the government expenditures we exclude:

·        Government transfer payment

·        Taxes…

Net Export: is the difference between the money value of import and the money value of export.


Now we are done with the components of the national account. Remember, we talked about GDP, Investment, Government, and Net Export.


Now let us move to talk about GDP “again!!”, NDP, GNP.


Even though the GDP is the most used measure to calculate a nation’s output, there are two other measures that are used also:  the NDP and the GNP.

Remember that GDP is the total amount of final goods and services produced in a country during a year plus the country’s gross investment.

Some clever readers will say Hey!! We shouldn’t include depreciation in the GDP; it is like counting something that doesn’t exist. Something that got depreciated.

You are right!!! Logically we shouldn’t, but practically, no one can evaluate a machine’s depreciation fairly, that is why and despite this weakness, statisticians and economists use GDP in national accounts.

If you still believe that it is not correct to use the GDP in national accounts, you can use another measure that takes in consideration depreciation. This measure is called the NDP. NDP = GDP – Depreciation.  But still, I don’t advise you to adopt the NDP, because as I said previously, evaluating depreciation is something subjective that cannot be demonstrated.

In addition to the GDP and NDP there is a third measure called the GNP.

The GNP or the Gross National Product is the total amount of goods and services produced by people having the same citizenship during a year.  

Example:    The production of a Japanese company that produce car in the U.S.A. will be counted in the calculation of the U.S.A. GDP but not in the calculation of the U.S.A. GNP. On the other hand, the production of a U.S.A. company in Japan will not be counted in the calculation of the U.S.A. GDP but it will be counted in the calculation of the Japanese GDP and the U.S.A. GNP.


National Income and Disposable income:

National income is the total income received by labor, capital, and land. It is constructed by subtracting depreciation from GDP. Then


NI = GDP – Depreciation = NDP = Wages + ∑Rent + ∑Interest + ∑Profit


Disposable income is the amount of money the household sector has to spend. How it is calculated?


DI = NI – Taxes – Net business saving (profits after depreciation - dividends) + Transfer Payment.



       Keep in mind that saving always equals investment. Further discussions about this point will be posted soon.


National Investment


Private investment + net exports = Private saving + Government saving


National saving


Price indexes and inflation:


A price index is a measure of the average level of price. Inflation denotes a rise in the general level of prices. The rate of inflation is the rate of change of the general price level and is measured as follows:


Rate of inflation

%Inflation (2001) = (CPI 2001- CPI 2000)/CPI 2000*100


Price Indexes:


Consumer Price Index: it is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI is calculated by weighting each price according to the economic importance of the commodity in question.  

GDP price index: also referred to as GDP deflator. The GDP price index is the price of all goods and services produced in the country rather than for a single component. It differ from the traditional CPI because it is a chain weighted index that takes into account the changing shares of different goods. 

Producer Price Index: it measures the level of prices at the wholesale or producer stage. It is based on approximately 3400 commodity prices.


Chapter 25 : Financial Markets and the special case of Money


In this chapter, we will be talking about finance, financial systems, financial markets, money, bonds, funds, insurances, securities,…

To those who are planning to specialize in Finance or Banking, this chapter is yours.


I-                   The Modern Financial System:

a.       The role of the financial system.

One sector of a modern economy which is of growing importance, involves finance and the financial system. By finance we mean the process by which economic agent borrow from and lend to other agents in order to consume or invest.

The activities involved in finance take place in the financial system. Important parts of the financial system include the money market, markets of fixed interest assets like bonds or mortgages, stock markets for the ownership of firms, and foreign exchange markets which trade the monies of different countries.

Borrowing and lending take place in the financial markets and through financial intermediaries.

Financial markets are like other markets except that their products and services consist of financial instruments like stocks and bonds.

Institutions which provide financial services and products are called financial intermediaries. Financial institution assets are largely financial rather than real (tangible)

The most important financial intermediate are

·        Commercial banks which take deposits of funds and lend these funds to those who need them.

·        Insurance companies.

·        Pension funds.

b.      The functions of the financial system.

                                                               i.      The financial system transfers resources across time, sectors, and regions. This function allows investments to be devoted to their most productive uses rather than being bottled up where they are least needed.

                                                             ii.      The financial system manages risks for the economy. In one sense, risk management is like resource transfer: it moves risks from those people or sectors that most need to reduce their risks and transfers or spread the risks to others who are better able to weather them. (Fire insurance example.)

                                                            iii.      The financial system pools and subdivides funds depending upon the need of the individual saver or investor. As an investor you might want to invest $10.000 in a diversified portfolio of common stocks. To buy efficiently a portfolio of 100 companies might require 10 millions dollars of funds. Here is where a stock mutual fund comes in: by having 1000 investors, it can buy the portfolio, subdivide it and manage it for you. (a well run mutual fund might charge you $30 for you $10.000’s portfolio.) Additionally a modern economy requires large scale firms which have billions of dollars of invested plant and equipment. No single person is likely to be able to afford that, and if there is someone who can, that person would not want all his eggs on a single basket. Here is where the modern corporation comes in, with its ability to sell shares of stock to many people and pool these funds to make large and risky investments.

                                                           iv.      The financial system perform an important clearinghouse function, which facilitates transactions between payers (purchasers) and payees (sellers). This function allows rapid transfer of funds around the world.


c.       The flow of funds.

Savers and investors transfer funds across time, space, and sectors through financial markets and financial intermediaries. Some flows (buying shares of XYZ company…) go directly to financial markets, while others (buying shares of mutual funds or depositing money in your checking account… ) go through financial intermediaries.

d.      A menu of financial assets.

Financial assets are monetary claims by one party against another party. These consist primarily of dollar dominated assets (whose payment are fixed in dollar terms) and equities (whose values represent the value of claims on real assets).

Here are the major financial assets:

                                                               i.      Money.

                                                             ii.      Saving accounts are deposits with banks, usually guaranteed by governments, that have a fixed dollar principle value and interest rates determined by short term market interest rates.

                                                            iii.      Government securities are bills and bonds of the federal, state, and local governments. They are guarantee repayment of principal on maturity and pay interest along the way.

                                                           iv.      Equities are ownership rights to companies. They yield dividends, which are payments drawn from the company’s profit.

                                                             v.      Financial derivatives are new forms of financial instruments whose values are based on or derived from the value of other assets. (stock option, which is an instrument whose value depends upon the value of the stocks to which it is benchmarked).

                                                           vi.      Pension funds represent ownership in the assets that are held by companies or pension plans.


e.       Interest rate and the return on financial assets.

When you borrow money or invest in different financial assets, you will naturally want to know what you will pay to borrow or earn on your investments.

These earnings are called the return on investments; in the special case of the return on fixed interest securities they are called the interest rate. From an economic point of view, interest rates or other returns are the price of borrowing or lending. Let’s focus on the important case of the interest rate.

The interest rate is the price paid for borrowing money. We usually calculate interest as a % per year on the amount of borrowed funds. There are many interest rates depending upon the maturity, risk, tax status, and other attributes of the borrower.

Higher Interest Rates Tend to Lower Asset Prices.

One important fact in Financial Markets is the inverse relationship between interest rates and asset prices.

The Present value of an asset is the dollar value today of the time stream of income generated by that asset.

Present Value—viewed another way:

Present value answers the question of how much money would have to be set aside today—and invested (at the appropriate interest rate)—in order to accumulate the target (payment) amount by the payment date.



f.        An array of interest rates:

Interest rates depend mainly on the characteristics of the loan or of the borrower. Let us review the major differences:

·        Loans differ in their term or maturity – the length of time until they must be paid off. Longer term securities and loans generally command a higher interest rate than do short term issues, because lenders are willing to sacrifice quick access to their funds only if they can increase their yield.

·        Loans also vary in terms of risk. Riskier securities might pay 1, 2, or 5 percent per year more than the risk less rate; this premium reflects the amount necessary to compensate the lender for losses in case of default.

·        Assets vary in their liquidity. An asset is said to be liquid if it can be converted into cash quickly at a reasonable price. Illiquid assets include unique assets for which no well established market exists.

Because of the higher risk and the difficulty or realizing the asset values quickly, illiquid assets or loans require higher interest rats than do liquid, risk less ones. 

When these three factors (along with other considerations) are considered, it is not surprising that we see so many different financial instruments and so many different interest rates. 

g.       Real Vs Nominal interest rates.

Let us suppose that you lend $100 today at an annual interest rate of 5%. At the end of the year, you would get back $105. But because prices changed over the years, you would not be able to buy the same amount of goods and services that you would have bought at the beginning of the year if you had $105.

Clearly, we need another concept that measures the return on investments in terms of real goods and services rather than in terms of dollars.

This alternative concept is the real interest rate, which measures the quantity of goods we get tomorrow for goods forgone today. This real interest rate is obtained by correcting the nominal interest rate for the rate of inflation.

The nominal interest rate, sometimes called the money interest rate is the interest rate of money in terms of money.

In contrast, the real interest rate is corrected for inflation and is calculated as the nominal interest rate minus the rate of inflation. 

II-                The special Case of Money:

a.       The evolution of Money:

What is money? Money is anything that serves as a commonly accepted medium of exchange.


                                                               i.      The history of money:

Because money has a long and fascinating history, we will begin with a description of money’s evolution.

In early times, all economic transactions were achieved through bartering. This was not easy and without problems.  “To barter means to exchange goods for other goods.” To come over this handicap, humanity created what we call today money. Money as a medium of exchange first came into human history in the form of commodities. A great variety of items have served as money at one time or another: oil, silver, rings, … each of the above has advantages and disadvantages.

By the eighteen century, commodity money was almost exclusively limited to metals like silver and gold. These form of money had intrinsic value, meaning that they had use value in themselves. Because money had intrinsic value, there was no need for the government to guarantee its value, and the quantity of money was regulated by the market through the supply and demand of gold and silver. The age of commodity money gave way to the age of paper money. Money is wanted not for its own sake but for the things it will buy. We do not which to consume money directly; rather, we use it by getting rid of it. Even when we choose to keep money, it is valuable only because we can spend it later on.

Paper currency is :

·        A convenient medium of exchange.

·        Easily carried and stored.

·        Its value can be protected from counterfeiting by carefully engraving.

·        The fact that private individuals cannot legally create money keeps it scare.

·        Given this limitation on supply, currency has value.

·        It can buy things.

·        As long as it is accepted as a means of payment, it serves the function of money.


                                                             ii.      Components of the money supply:

Let us now look more carefully as the different kinds of money, focusing on the U.S.A. The major monetary aggregates are the quantitative measures of the supply of money. They are known as M1 and M2.

1.      Narrow (transactions) money: One important and closely watched measures of money is narrow, or transactions, money, denoted M1, which consists of items that are actually used for transactions. The following are components of M1:

a.       Coins: M1 includes coins not held by banks.

b.      Paper currency:

c.       Checking account: There is a third component of narrow money – checking deposits or bank money. These are funds, deposited in banks and other financial institutions, on which you can write checks.

2.      Broad money: although M1 is, strictly speaking, the most appropriate measure of money as a means of payment, a second closely watched aggregate is broad money, or M2. Sometimes called near money, M2 includes M1 as well as other close substitutes for M1. More precisely, the components of M2 are:

a.       M1

b.      Saving accounts and small time deposits.

c.       Retail money market mutual funds.

These are near money because they are safe and can quickly be converted into M1.

Why are these not narrow money? Because they cannot be used as means of exchange for all purchases. You cannot go to a store and pay with funds from your savings account. 

b.      The demand for money:

The demand for money is different from the demand for ice cream or movies. Money is not desired for its own sake, but rather because it serves us indirectly, as a lubricant to trade and exchange.

                                                               i.      Money’s function: before analyzing the demand for money, let’s note money’s functions:

1.      Money serves as a medium of exchange.

2.      Money is a unit of account, the measure by which we measure the value of things.

3.      Money is a store of value.

                                                             ii.      The cost of holding money is the interest forgone from not holding other assets.

                                                            iii.      Two sources of money demand:

1.      Transactions demand for money: that is, because we need a generally accepted medium of exchange to buy goods and pay our bills.

a.       As our income rise the dollar value of the goods we buy increases, and we therefore demand more mony to make our transactions.

b.      As interest rates on alternative assets goes up relative to the interest rate on money, people and businesses tend to reduce their money holding. Knowing that the average money holding correspond to the demand for transaction money, we can deduce the following rule.

“Higher is the rate of interest, larger will be the deposit at the bank and lower will be the average money holding, therefore there is a negative relationship between the interest rate and the transaction demand for money.” 


2.      Asset demand for money: people sometimes hold money as an asset or store of value. But modern finance theory shows that narrow money (M1) should generally not be part of a well designed portfolio.


III-              Banking and the supply of money:

a.       How banks developed from goldsmith establishments:

b.      Modern fractional reserve banking:

c.       The process of deposit creation:

                                                               i.      How deposits are created: First generation banks.

                                                             ii.      Chain repercussions on other banks.

                                                            iii.      Find system equilibrium.

1.       The money supply multiplier.

                                                           iv.      Two qualifications to deposit creation:

1.      Leakage into hand to hand circulation.

2.      Possible excess reserves.



I will not be covering part C in this paper.





But wait



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IV-             The stock market.

We will end up this chapter with a tour through one of the most exciting parts of a capitalist system – the stock market. A stock market is a place where the shares in publicly owned companies, the titles to business firms, are bought and sold.

a.       Risk and return on different assets.

Before discussing major issues in stock market analysis, we need to introduce some elementary concepts in financial economics. We noted earlier in this chapter that assets have many characteristics, two of them are: (1) the rate of return (2) the risk.

                                                               i.      The rate of return is the dollar gain from a security (measured as a percent of the price at the beginning of the period). For saving accounts and short term bonds, the return would be the interest rate. For most other assets, the return combines an income like dividends with a capital gain or loss, which represents the increase or decrease in the value of the asset.

                                                             ii.      Risk refers to the variability of the returns on investment. economists often measure risk as the standards deviation of returns; this is a measure of depression whose range encompasses about two third of the variation.  (If you did not take a statistic course before, just do not try to understand this second definition of risk). Individuals generally prefer higher return, but they also prefer lower risk because they are risk averse. This means that they must be rewarded by higher returns to induce them to hold investments with higher risks. There is a positive relationship between risk and return. (This can be concluded or proved using the figure 25-5).



b.      Bubbles and crashes.

c.       Efficient markets and the random walk.

d.      Personal financial strategies.



I prefer to stop here. Please Read part D of the chapter on your text book. Economics 18e. It is very well written, I can not summarise it more for you.